Broker Beware

Bernie Haddigan estimates that a shopping center fields half as many offers today as it did a year ago. “But that's still enough to get it done,” he says of the new six-bid average. “We only need one buyer.”

Haddigan is a managing director at Marcus & Millichap and runs the brokerage's retail unit. Apparently he's an optimist, too. The long run-up in the commercial real estate market is beginning to turn, and brokers are bracing themselves for change.

Since the stock market tanked in 2001, real estate has been an attractive alternative. And a thriving housing market, fueling demand for consumer goods, reinforced the allure of retail properties: Marcus & Millichap says it has grown its retail business 35 percent to 40 percent annually for five years; Sperry Van Ness of Irvine, Calif., reports that 2005 saw sales transactions valued at $9.5 billion, seven times those in 2001. But now prices of retail developments have reached the point where rents are hard-pressed to keep pace. Add to the mix rising interest rates and investors are thinking twice about buying in.

“No question we've had a pretty good ride,” says Jerry Anderson, president of the Sperry Van Ness National Advisor Organization. “But anybody who has been in the business 10 years or less doesn't know what it's like on the downside.”

That includes a lot of brokers since the bust of the early 1990s. “I think one of the changes we face is that mediocrity is not going to guarantee success,” says Anderson. “In the past few years, quite frankly you didn't have to be that good to succeed in the commercial real estate industry.”

So we may be reaching a point at which experience kicks in. Brokers are helping investors identify and ride long-term trends including urban revitalization, mixed use and redevelopment of suburban locations.

With interest rates rising, 23-year veteran Todd Caruso, a senior managing director with CB Richard Ellis retail services in Chicago, is particularly worried about the steady proliferation of lifestyle centers, which tend to be more capital-intensive to build and therefore more difficult to generate high initial yields.

Caruso cautions prospective investors that the concept is so popular that some lifestyle projects are ill-conceived and have little prospect of feeding investors decent returns either now or in the future. “For them to pay aggressively in an environment where rates are increasing just puts heavy strains on their yield,” warns Caruso. “If they're not in a position to increase rents, I think it makes for a very tough long term.”

And those rents are beginning to peak. “If they're not at the top in some markets,” says Caruso, “they're certainly nearing it.”

The new tide is forcing brokers to get their hustle on. “It's much more difficult for buyers to find property,” says Haddigan. However, “a transitioning market creates buying opportunities you wouldn't get in another market.” For example, if that big box on the corner turned out to be a bomb, buy it at a discount, chop it up and retanant it with boutique shops.

Flipping properties

With cap rates in big markets faltering, brokers also are pointing their investor clients to lesser tiers where acquisition costs tend to be lower. The Rochester Democrat and Chronicle newspaper notes, for example, that more than half the commercial space in Rochester, N.Y., has passed out of local hands in the past decade, including the $2.3 billion sale in 2004 of a retail portfolio to Developers Diversified Realty Corp. and another $2.3 billion in local retail properties last year to Macerich Co.

“More savvy buyers are not looking in their backyards,” says Haddigan. “Lots of capital is moving across boundaries.” Brokers now can quickly compare properties from the Atlantic to the Pacific, Atlanta traffic counts versus Dallas versus Las Vegas.

This creates an interesting new chaos. A broker who knows the local market can advise on whether a project or store will work, of course. On the other hand, an outsider's fresh eyes may see opportunity that longtime observers miss. Local brokers “remember what used to work,” says Haddigan. “Outsiders are trying to anticipate how the market is going to evolve.”

The big picture is the new paradigm. When the flood of money entering commercial real estate begins to abate, buyers, sellers, landlords and tenants will negotiate harder. That's where brokers may come to the fore. The only thing the landlords may know, for example, is they have vacant space and they expect to get a certain amount per square foot when leasing.

What prospective tenants are willing to pay, however, depends on the rest of the market. If a space glut is emerging and landlords don't know it, they may turn down offers they think are too low. And they may not get that offer again. As the market transforms, says Anderson, “you'll find the talents of the brokerage community are needed more than ever.”

Some decision makers will always see real estate as the best choice, no matter what. Sheri Messerlian, senior vice president at NAI Capital in Torrance, Calif., marvels at a Chinese investor who bought a big-box location despite struggling restaurants and vacant retail space.

“There will be money going into the mall no matter what,” she concludes. “People like real estate.”

Still, Anderson predicts, “The top agents and brokers in this country are going to become more valuable as the market tightens up.” And how will we know when the market is about to turn? Haddigan shrugs: “After it happens.” It won't only be the strong who survive this next chapter, but how many more is anybody's guess.

The New Math

How well do you know retail leasing? Take this quick quiz: We say Wilshire Boulevard. You think long commercial corridor where thousands of vehicles tread but few slow for amenities. Not a good place for yet one more coffee shop.

Well, think again. Recently, demand for housing has spread along these arteries. And that has persuaded some developers to turn intersections into modest destinations, one-acre happenings — retail nodes, in other words. “You create a sense of place,” says Marty Shelton, vice president with NAI Capital Inc. in Los Angeles. “Mixed-use, walkable, pedestrian-friendly.”

Tenant brokers like Shelton have their work cut out for them. “Retail is always perceived to be in motion because social values change,” says Sheri Messerlian, senior vice president with NAI Capital in Torrance, Calif.

The shifting complexion of inner cities like that in L.A. is just one national trend that's keeping tenant brokers on their toes. Another is the transition from pure retail locations to mixed use. Adult daycare, doctors' offices and other services “want to have visibility on major boulevards,” says Messerlian. Consequently, more factors come to bear on finding a good location. Decisions that used to rely on simple traffic counts now hang on who's next door, what restaurants are nearby, and whether or not anybody will be able to find you.

Lifestyle centers have rewritten the playbook, too. Even a store stuck in a corner of a big enclosed mall is all but assured a share of the traffic, says David Schulman, president and CEO with ChainLinks Retail Advisors Inc. in Atlanta. A store with a bad spot in an outdoor lifestyle center, however, may never see some of the people who pull in, shop and drive away. Lifestyle center costs are significantly lower than the best enclosed malls in town — and that makes sense, since who knows how far people will walk in bad weather.

Good local representation for tenants is more important than ever, Schulman argues, especially as new construction levels off and existing locations fill up. “As development slows down, it's much more difficult for a retailer to find the right location,” says Joshua Jacobs, broker with Page Partners in Houston. “Number one, because it might be taken.”

And if you find a good spot, the rent might knock you over. Investors' demand for top rents is perhaps the biggest variable in today's leasing environment. In some parts of New York City, for example, retail rents rose up to 32 percent in mid-2005, according to the Real Estate Board of New York.

“But rent is only one of the factors that makes a difference whether you take the space,” argues Joanne Podell, who works the New York City market as senior director and top broker with Cushman & Wakefield Inc. “If you have good margins, that changes the numbers.”

And some markets are special. New York City is an entry point where foreign retailers get a quick read on whether they can make it in the U.S. And then there's the glamour of a totally hot location. Retailers count the staggering rents at some locations as part of their marketing and advertising budgets. A shop on Madison Avenue, claims Podell, is as good as an ad in Vogue.

Elsewhere, however, tenants pushing back against rising rents may be the pinprick that pops the bubble in property prices, according to John Beaney, senior vice president for retail tenant services at Colliers International Inc. of Los Angeles. “At some point companies will balk at the rent and say this just doesn't make sense.”

Leasing brokers meanwhile scour for good locations in smaller markets, where development costs and rents align more favorably.

The rents may be cheaper out in Podunk, but Beaney also warns of different market dynamics. These towns' malls may draw from 30 miles away — a much greater market area than the five- to seven-mile pull of a suburban mall in a big metro area. “If you can get in first you can own the market,” he says. “Usually there isn't room for two.”

Not that Beaney hasn't tried. In late 2005 he popped a Linens-n-Things store into Park City, Utah, just 100 yards from Bed Bath & Beyond. His client “wanted to be on at least a level playing field,” but, he concedes it was an aggressive move. “I think that's a sign of the times.” — MH